Column: Invest like Fama but regulate like Shiller

(Reuters) – If the board awarding this year’s Nobel Prize in economics didn’t get bogged down in a foolish consistency, there is no reason for you to.

The award this year went to Eugene Fama, Robert Shiller and Lars Hansen, leading to much hand wringing over the apparent conflicts between the work of Fama and Shiller. (Hansen is mostly known for research on risk, which may be why so few are discussing him.)

Fama is famous for the efficient markets hypothesis, which posits that securities prices reflect all available information, which on the face of it makes quite a contrast to Shiller’s central assertion that animal spirits – greed and fear, to you and me – drive financial markets and make bubbles a regular feature.

First off, economics is a social science, not a hard science, so don’t kid yourself that anyone has the final word on anything. You may as well go to the opera in hopes of finding out whether it will rain next week.

That said, there is much of use in both men’s work, and employing a strategy often used by Nassim Nicholas Taleb, perhaps we can boil it down to the following rules of thumb:

Regulators and central bankers ought, in general, to behave as if they believe Shiller, while investors, by and large, will be far better off if they heed the lessons of Fama.

If both those rules of thumb had been followed the past 20 years, you, dear reader, would likely be living in a society with greater economic output and less-damaging economic volatility, while looking forward to a more secure retirement due to having more in savings.

SHILLER FOR FED CHAIR

Remember Citigroup chief Chuck Prince’s comment, just before the crash, about how you have to dance while the music is playing? That was an acknowledgement of how commercial pressures (and personal gain) prompt banks to keep pouring on credit even when things seem to be getting out of hand. That this happens is something well understood by Shiller, in a way Alan Greenspan never understood, or never allowed himself to understand.

Greenspan, and other regulators and central bankers, bought in to a kind of triumphalism that sees market finance as both un-erring and self-policing. You can’t exactly lay this at Fama’s feet, as it is a perversion of his work, but Shiller demonstrated that markets make errors. His insight, that psychology plays a key role in setting prices, was very much out of the mainstream when he began enunciating it two or three bubbles ago.

Had Greenspan, and others, made monetary policy and regulated finance in a Shillerian spirit, with a keen eye on greed and fear, we almost certainly would have had fewer bubbles. It also follows quite naturally that in a world with bubbles driven by irrational behavior you would force banks and other key institutions to hold high levels of capital.

FAMA FOR CHIEF INVESTMENT OFFICER

Perhaps Fama’s biggest contribution to the happiness and sanity, not to mention wealth, of the average investor is in providing the intellectual underpinnings for the growth of the index fund movement.

“Research generally has failed to find that mutual funds generate positive returns above what can be motivated by the level of risk; once fund fees are taken into account, their asset management often yields negative excess returns,” according to a statement from the Swedish Royal Institute of Sciences, which chose the winners.

Markets, Fama’s work in the 1960s tried to show, were the distillation of all available information, making predicting their future movements essentially pointless.

The takeaway, as far as you and I are concerned, is that markets are efficient enough, enough of the time, to make it not worth your while to indulge in active management.

Later work by Fama, who teaches at the University of Chicago, backed away from the hardline efficient markets world-view, finding that other stock traits, such as momentum, can help to explain stock movements.

A 2010 paper Fama authored with Kenneth French of Dartmouth, found that just 3 percent of mutual fund managers demonstrated meaningful skill, about the same number as would be produced by chance.

Three out of 100 doesn’t look like very good odds to me, and so most people, in most circumstances, should lean heavily on index funds for their investments.

Those two ideas, that people are driven by fear and greed and that markets are tough to beat anyway, are perhaps are not in such opposition after all.

(James Saft is a Reuters columnist. The opinions expressed are his own.)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)